Early Redemption of ‘Cocos’: Win for LBG in Supreme Court

Almost like the British public on Brexit, the Supreme Court remained closely divided on the issue of whether the Court of Appeal erred in its construction of the terms of enhanced capital notes (ECNs) by relying on technical and specialist information as part of the factual matrix. Formally described as ECNs, the loan notes were contingent convertible securities (or “Cocos”). Lord Neuberger (with whom Lord Mance and Lord Toulson agreed) dismissed BNY Mellon’s appeal whereas Lord Sumption (with whom Lord Clarke agreed) would have done otherwise. As Lord Sumption said in his brief note of dissent, the case was “of considerable financial importance to the parties” but it raised “no questions of wider legal significance”. The outcome in the case is a major blow for investors (receiving up to 16pc interest) who had hoped that the court would not have held that the terms of the bonds (or ECNs) allowed Lloyds Banking Group (LBG) to redeem them early at face value. The High Court found in favour of the bondholders but the Court of Appeal reversed that decision, one that the Supreme Court has upheld: albeit not without doubts and dissent. Led by Mark Taber, the bondholders disputed that the ECNs had been disqualified as capital and resorted to litigation. A disgruntled Taber said that the division between the justices “raises massive issues over the role of the regulators”.

He is particularly aggrieved that the court’s judgment does not engage with the arguments aired about statutory requirements that bond prospectuses must be accurate and provide crystal clear information to investors so that they may make informed choices and decisions. Worse still Taber also complains that he lobbied the FCA’s new boss Andrew Bailey to make germane information – about the exact scope of the regulator and LBG’s knowledge about impending changes to capital requirements when the ECNs were issued – available to the court. But since his request was not granted, he argues that because the courts are not willing to intervene it must be the City regulator’s job to interpret the prospectuses. “I believe the changes they knew about, which were not disclosed in the ECN prospectus, meant that a capital disqualification event was a certainty at the time the ECNs were issued. If the court had been told this I think it would have made a difference,” is how Taber expressed his frustration with the situation. However, his claim appears to directly contradict even Lord Sumption’s dissenting judgment that despite its financial importance the appeal contained no legally significant questions of wider importance.

Context

LBG, which suffers from a murky legacy of Payment Protection Insurance (PPI) mis-selling and in which the government has a 10 per cent stake, is one of the big four British banks: the other three being Barclays, HSBC and of course the state-backed disaster (with 73 per cent government ownership) that RBS has become. For example, RBS’s failure to launch the sale of Williams and Glyn by June 2016, a self-imposed deadline, because of technological issues was a bad enough failure on its own. But now with Brexit, plans to postpone the sale of the government’s shares in RBS appear to be the final nail in its coffin. The sale of government shares in LBG, which is the largest retail bank in the UK, has also been postponed. Yet the chief executives of both banks have reassured staff that their banks were in a position to withstand the negative effects of the Brexit vote.

This appeal involved the issue whether LBG had been entitled to redeem £3.3bn of ECNs, which carried an interest rate of over 10pc per annum. Lord Neuberger of Abbotsbury, who in an earlier life worked as a Rothschild banker himself between 1970-73, sketched the background to reflect that when the ECNs were issued the CRD I Directive set out the capital requirements for financial institutions. CRD I classified the capital of financial institutions in tiers of which Core Tier 1 (CT1) was the highest.

The FSA, which was supplanted by the FCA and the PRA in April 2013 under the statutory scheme created by the Financial Services Act 2012, required LBG to raise £21bn which could qualify as CT1 Capital after stress-tests revealed a shortfall which meant that LBG failed the stress test carried out by the FSA in March 2009. In its bid to raise capital, which proved successful with 86pc take up, LBG issued £8.3bn of ECNs in December 2009 to a mixture of institutional and retail investors. The restructuring was carried out by way of an exchange offer memorandum sent to holders of existing securities, including around 123,000 retail investors. The bonds aimed to meet criteria set out by the FSA in September 2009, which provided that hybrid capital instruments capable of supporting CT1 Capital by means of a conversion or write-down mechanism at an appropriate trigger could qualify as CT1 Capital.

A Trust Deed recorded the detailed terms and conditions (T&Cs) of the ECNs. It was not possible to redeem the ECNs until specified maturity dates. But the exceptions were twofold. They could be redeemed if they were converted into shares on the occurrence of a conversion trigger, being any time when LBG’s CT1 ratio fell below 5pc. They could also be redeemed early by LBG on the occurrence of a Capital Disqualification Event (CDE). Under clause 19(2) one of the two circumstances in which a CDE occurred was where as a result of any changes to regulatory capital requirements, the ECNs ceased to be taken into account in whole or in part for the purposes of any stress test in respect of the Consolidated CT1 ratio.

Under the new CRD IV Directive (2013/36/EU), CT1 Capital was replaced in June 2013 with a more restrictive category called Common Equity Tier 1 Capital (CET1 Capital) and CRD IV effected other changes to capital requirements. Because of the changes, the PRA confirmed that LBG was subject to a new 7pc CET1 ratio standard and that the ECNs would need to have a trigger for conversion higher than 5.125pc CET1 in order to count as core capital.

ECNs worth £5bn were exchanged in March-April 2014 by LBG for instruments satisfying the new requirements and in December 2014 the PRA found LBG’s CET1 ratio to be 10.1pc and its minimum stressed ratio to be 5pc but it did not take the ECNs into account in either assessment.

LBG announced on 16 December 2014 that it was entitled to redeem the outstanding £3.3 billion ECNs because a CDE had occurred under clause 19(2). As trustee for the ECN holders, BNY Mellon Corporate Trustee Services Ltd (BNY Mellon) issued proceedings challenging LBG’s claim and refuted that a CDE had occurred. As the claimant trustee, BNY Mellon sought a declaration that a that a CDE had not occurred because the December 2014 stress test was not relevant to clause 19 as it had been conducted by reference to a CET1 ratio rather than a consolidated CT1 ratio. It also argued in the alternative that the fact that the ECNs had not been considered in the December 2014 stress test was not enough to trigger a CDE. Instead, it mounted the argument that the ECNs had to have been disallowed in principle from being taken into account for the purposes of the tier 1 ratio.

Sir Terence Etherton rejected the first point but nevertheless reasoned that the second argument had merit and he therefore declared that a CDE had not occurred: see [2015] EWHC 1560 (Ch). However, despite first instance success for BNY Mellon before Sir Terence Etherton, the Court of Appeal allowed LBG’s appeal: see [2015] EWCA Civ 1257 (Briggs, Sales and Gloster LJJ). The two issues in the Supreme Court were whether (i) the possibility of a CDE fell away following CRD IV and (ii) had the ECNs “ceased to be taken into account”?

The Supreme Court

Guidance was imparted on the scope of taking background materials when interpreting a contract or trust deed which governs the terms on which a negotiable instrument is held.

The view of the majority was that it was not possible to understand the Trust Deed without understanding of the regulatory policy of the FSA at and before the time that the ECNs were issued. It was possible to interpret the T&Cs in light of the general “thrust and effect” of the regulatory information available in the public domain in 2008 and 2009. It was clear that when construing a contract or Trust Deed which determines the terms pursuant to which a negotiable instrument is held very considerable circumspection is appropriate before the contents of such other documents are taken into account.

BNY Mellon’s argument that the December 2014 stress test was not “in respect of Consolidated CT1 ratio” as specified in clause 19(2) of the T&Cs because CT1 had by then been replaced by CET1 Capital was rejected by Lord Neuberger. Discussing authorities such as Egyptian Salt and Soda Co Ltd v Port Said Salt Association Ltd[1931] AC 677, Attorney General of Belize v Belize Telecom Ltd [2009] 1 WLR 1988, Homburg Houtimport BV v Agrosin Private Ltd[2004] 1 AC 715 and Chartbrook Ltd v Persimmon Homes Ltd[2009] AC 1101 put to him by BNY Mellon, his Lordship applied the decision in In re Sigma Finance Corp (in administrative receivership)[2010] 1 All ER 571 and went on to hold:

35. I have no hesitation in agreeing with Sir Terence Etherton and the Court of Appeal in their conclusion that the reference to “the Consolidated CT1” in para (2) of the Definition should, in the events which have happened, be treated as a reference to “its then regulatory equivalent” – i.e. in the current context the Common Equity Tier 1 Capital. Etherton C and the Court of Appeal considered that this conclusion involves a departure from the strictly literal meaning of the definition of “CT1 Capital” in clause 19, but they concluded that such a departure was justified because it was “clear that something has gone wrong with the language and [it was] clear what a reasonable person would have understood the parties to have meant”, applying the test laid down by Lord Hoffmann in Chartbrook, para 25.

For Lord Neuberger, in construing the reference in clause 19 of the T&Cs to Consolidated CT1, it was relevant to take the following five points into account:

it was notorious at the time of the issue of the notes that financial institutions’ capital regulatory requirements would be strengthened and changed.

it was envisaged in the trust deed’s terms and conditions, in particular in clause 19, that expressions such as CT1 capital could change their meaning.

it was inherent in the terms of the definition of a capital disqualification event that that was so.

it was obvious that changes of substance might lead to changes of nomenclature.

one of the essential features of the notes was that, if necessary, they could be converted into core capital, whatever expression was used to define it.

Lord Neuberger found that because of the above points and the existence of the notes’ maturity dates it made no commercial sense to restrict the reference to consolidated CT1 ratio in the definition of a capital disqualification event to CT1 capital, as opposed to holding that it could, in the events which had happened, apply to its then regulatory equivalent, CET1 capital.

BNY Mellon raised another argument regarding whether the ECNs “ceased to be taken into account”? It said that, for para (2) of the Definition to apply, the ECNs must be disallowed in principle from being taken into account for the purposes of the Tier 1 Ratio before LBG can invoke para (2) of the Definition. Putting the point in slightly different words, Lord Neuberger clarified that the question involved consideration of whether the implementation of CRD IV by the PRA through the new Capital Requirements entitled LBG to say that a CDE had occurred because para (2) of the Definition had been satisfied. Critically, the point involved consideration of whether it was sufficient that the ECNs continue to be taken into account for some purpose in the stress-test, or whether they must play a part in enabling LBG to pass that test, which they no longer did.

Lord Neuberger preferred the view that the ECNs must play a part in enabling LBG to pass the stress test. The court affirmed the [2015] EWCA Civ 1257 decision of the Court of Appeal given by Gloster, Briggs and Sales LJJ and at para 45 his Lordship held:

First, it appears to me that the Trustee’s argument does not give full weight to the phrase “any ‘stress test’ … in respect of the [Tier 1] Ratio”. I accept that, under the new Regulations introduced in 2013, the ECNs could be taken into account in a “stress test”, and I accept that there could be circumstances in which the ECNs could convert into ordinary shares so as to become part of Tier 1 capital. However, if and when a stress test is applied to see if LBG satisfies the Tier 1 Ratio, it appears to me that the vital point is that, under the Regulations introduced in 2013, the ECNs cannot be taken into account so as to do the very job for which their convertibility was plainly designed, namely to enable them to be converted before the regulatory minimum Tier 1 Ratio is reached. That, to my mind, is what the expression “taken into account … for the purposes of any ‘stress test’ … in respect of the [Tier 1] Ratio” is concerned with.

For his Lordship, the same conclusion was also apparent by comparing the words in clause 19(2) (“ceased to be taken into account”) with clause 19(1) (“no longer eligible to qualify”). Even if the contrary view was accepted as correct, it was very hard to contemplate circumstances in which it could have been thought that clause 19(2) could have been invoked. Lord Neuberger found the closing words of the Trust Deed to be “inherently imprecise” but he did not think ambiguity should be construed against LBG. In fact, arguments mounted on the basis of the contra proferentem rule were seen by the court as a “last refuge, almost an admission of defeat” and it was held that the Trustee’s appeal should be dismissed on the basis that a CDE has arisen under clause 19(2).

Dissenting from the majority view, Lord Sumption (with whom Lord Clarke concurred) would have held that ECNs were not redeemable. He reasoned so because, irrespective of their status as lower tier capital, the ECNs would be treated as top-tier capital by the regulator in the hypothetical event that LBG’s affairs deteriorated to the point where the conversion trigger was attained.

Comment

As seen in Seven Deadly Sins, the culpability codes for conduct costs of LBG for the period between 2008-2014 reveal quite a disturbing picture. Corporate integrity-related regulatory breaches, such as PPI mis-selling, cost LBG almost £2.5bn alone in 2014 and corporate conduct/behavioural failure added another £1bn to the conduct bill for the same period. Other misconduct such as false LIBOR reporting (see here and here) has also led to the imposition of fines on LBG.

As for Brexit, Martin Wolf has argued this weekend that the decision to leave the European Union will not come cheap. He concludes “Britain has prospered inside the EU but it will not do as well outside”. Alas, economic doom awaits the UK and financial disarray, a low pound and crashing property prices will preoccupy people in the upcoming months and years. Predicting widespread damage to business and the economy Wolf excoriated Boris Johnson, Michael Gove, Nigel Farage, The Sun and the Daily Mail for their “fear mongering and outright lies”. Similarly, one would have to agree with Janan Ganesh that Cameron, “who always looked like the incarnation of common sense” but “gave his nation chaos”, has been forced to exit Downing Street even more ignominiously than Antony Eden who was given an extremely bloody nose by Gamal Abdel Nasser – or “The Last Arab” – during the 1956 Suez Crisis.

Cameron clearly made a huge miscalculation. But now the huge problem confronting the UK is that, due to Brexit, London’s reputation and standing in the global financial services industry is put at huge risk because the City faces losing “EU passporting rights” which are critical to its future survival as they allow financial firms to sell products across the EU from London (where 100,000 jobs in the financial services sector may be axed because of Brexit). Indeed, other predatory European financial centres will only be too happy to coax lenders away from London.

Things immediately turned sour for the City and the banks when Lord Hill, the Conservative peer (formerly) in Brussels as the UK’s European Commissioner in charge of financial services, resigned because he found it inappropriate to continue in his role because of his preference to remain in the EU. He quite rightly feels that the City of London has “lost its voice” because of the referendum result in favour of Brexit.

To make matters even worse, as the UK begins its journey into the unknown, fears stoked by the referendum result swiftly led Moody’s to cut the UK’s debt rating from “stable” to “negative”. Equally, Standard and Poor’s has also stripped the UK of its longstanding AAA debt rating – by downgrading it to AA (negative) – as a consequence of the fallout from the referendum. Share prices in the big banks are also plunging. After the vote, shares in RBS fell by 30pc and Barclays (down 32pc) and Lloyds (down 28pc) have also been badly hit. HSBC has not been affected as much because of the truly global nature of its operations. But the challenger banks have been hit even harder than big lenders and up to 45pc wipeouts in their share value are being reported. It is hard to laugh all this off because things are looking ominously close to the onset of the Global Financial Crisis in 2007-2008.

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